Freakonomics, Separating Equilibria, and Pricing

Do you like Freakonomics? I sure do. Levitt and Dubner’s latest book, “Think Like a Freak”, is a fun read which I highly recommend. But I had to think hard about chapter 7, “What do King Solomon and David Lee Roth have in common?”.

If you haven’t read that chapter, you should, but here’s a very quick synopsis. (spoiler alert) Both King Solomon and David Lee Roth used game theory to create separating equilibria. This essentially means they set up a “game” so that people inadvertently reveal their true identities.

One of their examples was why David Lee Roth used to ask for M&M’s with all of the brown M&M’s taken out. At first glance this seems like another wacky, self-absorbed superstar demanding eccentric treatment. However, David Lee Roth added this requirement for a very strategic reason.

When they were touring, they had a wild show, with pyrotechnics, lights, complex stages and heavy speakers. If the stage was not set up exactly as the contract specified, someone could get hurt. So how could Roth know which venues carefully read the contract and set up the stage according to specifications? He needed a separating equilibrium where he could tell the two different types of venues apart.

So Roth buried a clause deep in the contract stating he wanted his special serving of M&M’s. When he showed up at a site, if his M&M’s were there, without brown ones, he was more confident that the contract was read and followed carefully. If not, they assumed the contract was not read carefully so they had to carefully check the entire setup.

Why is this a separating equilibrium? Because two different behaviors indicated two different “types”. Venues who didn’t read the contract carefully wouldn’t serve the M&M’s properly. Those who did read it would. Just by looking for M&M’s he was able to tell which group read the contract and which didn’t.

After reading this, two questions came to mind. 1. How do we set up our own separating equilibria? and 2. What does this have to do with pricing? Sorry, but I haven’t figured out how to answer question 1, but question 2 is what prompted this blog.

Is there a mechanism which produces a separating equilibrium whereby we can distinguish customers with high willingness to pay from customers with lower willingness to pay? Yes. Think coupons. Only people who are price sensitive go through the hassle of finding, clipping, storing, carrying and remembering to use coupons. People who are not price sensitive don’t.

We can use a similar concept to create more separating equilibria. In essence, anything that offers a discount for effort (or anything negative) would be a separating equilibrium. Imagine when you get to the grocery store checkout, the clerk offers you a discount if you let her stab your arm with a thumbtack. Some people, who are very price sensitive, might say yes. Most of us would not. That is a separating equilibrium.

Okay, maybe that last example was over the top. Besides coupons, are there any other separating equilibria in use in pricing today? Sure. Think about who shop at stores like Macy’s, who have frequent sales. Some people just walk in and buy what they want when they want it. They are not price sensitive and usually end up paying full price. Others wait for Macy’s to have a sale and then shop. Only price sensitive people are willing to wait.

Many stores, including Macy’s, will offer you a discount on a full price item if you ask. However, only price sensitive people have the gumption to be willing to ask for a discount. In January 2014 NPR’s This American Life (available on podcast) had a fun story on one of their producers trying to get the “good guy discount,” simply asking for a discount. It certainly doesn’t always work, but it does sometimes.

You never know when or where we can learn pricing lessons, but it’s certainly fun learning them from the Freakonomics guys.